Should I or shouldn’t I?
QR National is the second biggest float in Australia’s history and if I, as a value investor, am to be focused on extraordinary businesses, bought at discounts to intrinsic value, then the second biggest float ever deserves some of my attention.
But is QR National an extraordinary business? And is it available at a discount to its intrinsic value? They are the questions I need to answer.
QR Limited reported a loss of $37 million in 2010 (The Prospectus Appendix reports the continuing operations of QR Limited lost $37 million in 2010). A company-wide restructure, combined with customers rolling off old contracts and onto new, more commercial ones, as well as continued growth in coal haulage volumes however, is expected to result in a profit of $369 million in 2012 (and possibly much higher beyond that).
QR National will start its listed life with a balance sheet that has about $6.8 billion of equity. If QR National hits its targeted profits and pays its estimated dividends over the next 18 months, that equity will grow to $7.3 billion (I have excluded the impact on equity of the proposed dividend reinvestment plan). And if QR National hits its 2012 profit forecast, return on average equity will reach 5.1 per cent.
(POSTSCRIPT; Much is being made of the profits beyond 2012 and the return on the $3 billion invested. I had the opportunity to discuss this with L.Hockridge and he pointed to the prospectus forecast for an EBITDA run rate of $170-$190 million. Aside from the fat that EBITDA is nonsense the NPAT return on capital at maximum capacity will be about 6%. I talk about this below so I am not too worried about using the 2012 for a few years beyond it. In any event if 2015 and beyond is where the rewards are; why the rush to invest today?)
Given that I can invest in companies generating 40%, 50%, 60% even 80% returns on equity, should I consider a return that is less than that which cash in the bank generates?
Because the dividend yield is so miserly (and because of negative cash flow after capital expenditure, those dividends are effectively funded out of borrowings) the company is being pitched as a growth stock and growth story. Growth in coal volumes transported is the validation for the claim. But when a company generates a 5% return on the profits they keep, you don’t want it to grow. It is better they hand all the profits back to you so that you can put the money in the bank and get a higher and safer return. Of course they can’t hand the profits back to you because the cash flow won’t support it for reasons I explain next.
QR National is a capital intensive business and even before dividends are paid, the cash flow will be negative. Between 2008 and 2012 (5 years) QR National will have expended $7.2 billion on ‘capex’ and the company will need to borrow $1.5 billion in the next few years (the prespectus explains it will draw on over $2 billion). This will partially cover the gap between the capex and the cash form operations of $3.4 billion. The returns the company will be aiming for on this debt funding could be nine per cent or more, but my estimate is that the $170-$190 million in EBITDA from its GAPE project disclosed in the prospectus will be whittled down considerably by depreciation, interest and tax, such that the additional contribution to return on equity of the whole group may not be so significant.
As an aside the prospectus spends a great deal of time focusing on EBITDA (earnings before interest, tax, depreciation and amortisation) but as Charlie Munger once observed, whats the point of looking at “earnings before costs”? And as Buffett noted, the “tooth fairy” doesn’t pay for these things. Depreciation is a very real expense even though many finance professionals treat it as a non cash accounting item. In reality when depreciation is based on the historical cost of an item, it will under-provide for the true cost of maintaining and ultimately replacing that item. This is because the depreciation is based on the purchase price of the item many years ago, but maintaining and replacing it will suffer the impact of inflation. Thinking about it another way; imagine employing a thousand people for ten years but paying for them upfront and expensing the cost over ten years – would you then say the item is non cash and can be ignored? The real cost of employing these people will be higher than the depreciation suggests – they will demand salary increases. Looking at earnings before real costs is nonsense. Buffett’s advice from his 1989 letter to Berkshire Shareholders is even less accommodating: “Whenever an investment banker starts talking about EBDIT – or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – zip up your wallet.”
One other point: it appears to me that forecast profits (and by inference the 2012 Return on equity of circa 5%), may be boosted by some permitted accounting tricks. The future profits may be boosted by the capitalisation of interest on debt used to finance assets under construction. In other words not all of the interest expense in 2012 is flowing through the forecast profit and loss statement. Some of it will be capitalised (converted to an asset on the balance sheet). Telstra has done this with software development expenses and the end result is a profit figure that looks better than economic reality. For QR National it means that $369 million profit reflects accounting reality rather than economic reality.
I appreciate two things about this float. First, some of the smartest operators and management in the country are now driving it and as they point out, quite rightly, prospectus requirements limit their ability to discuss what happens beyond 2012 (but beyond 2012 anything can change, even management themselves). If however, it is the case that returns on equity will creep towards double digits after 2012, then I must ask myself if there is there any urgency to buy today?
The risk of course is the cost associated with paying a higher price for the shares at some future date when the wonderful performance is confirmed. The second thing I appreciate is that I cannot predict what the share price will do. The vendors and their advisors are pulling out every device designed to support the price of the shares after the float. There is the loyalty bonus that incentivises retail investors not to sell until December next year, and there’s the greenshoe permit that allows the managers of the float to step in and buy shares in the aftermarket. The share price may very well perform brilliantly. I am the first to admit that I am no good at predicting what the shares will do. That is the main reason why I always say you must seek and take personal professional advice. Your adviser is the only person who understands whether QR National or any company and their shares are suitable for you.
I estimate QR National’s shares have a 2012 intrinsic value of between $1.09 and $1.48, but thats in 18 months time. Given there will be 2.44 billion shares on issue, the intrinsic value of the whole business is about $3.7 billion in 2012. The intrinsic value is necessarily less than the equity or book value on the balance sheet because the equity is forecast to produce a lower return than that which I require from a business. The vendors want you today to pay up to double the 2012 intrinsic value ($2.40-$2.80 per share – loyalty bonus and Queensland resident bonus excluded).
I may indeed miss out on some gains if I don’t participate in the float, and I may miss out on very substantial gains. Of course there is the risk of loss too if I do participate. While I might be ok with either scenario, you may not be and so YOU MUST SEEK AND TAKE PERSONAL PROFESSIONAL ADVICE. My comments are general in nature and I have not taken into account anything about you or your financial needs and circumstances. If you want advice about what to do regarding the QR National float, speak to your advisor and if you haven’t got one, seek one out BEFORE doing or not doing anything.
Postscript: as one of my friends, Chris – also a fund manager – noted this morning: “I haven’t looked at the detail yet, but thought it was worth pointing out that the EV/EBITDA multiples they’re using might be a touch disingenuous. QR are using FY12 earnings on today’s balance sheet (i.e. current net debt of $500 million) despite the fact that they’ll have to drw down on at least $1.5 billion of further debt to generate those earnings. Essentially you might like to have someone check if they might be using today’s balance sheet and tomorrow’s earnings to lower the multiple.”
On a more navel gazing note…
Short-term price direction is not the trigger for a change of heart towards a company. Indeed, a falling price for an A1 business generally represents an opportunity. Sometimes however the nature of price changes has me sitting up and taking notice – being alert rather than alarmed.
Currently, JB Hi-Fi’s share price has been heading in the opposite direction to that of most of the A1 companies that I am following. Such determined selling has often been the precursor to an announcement. Let me make it clear that other than knowing JBH will hold its AGM tomorrow in Melbourne, I don’t know whether an announcement, for example a trading update, will be forthcoming or not. The rather unidirectional nature of the price changes however, often bodes poorly for the contents of any announcement. Keep a watchful eye therefore on JB Hi-Fi.
I found at my recent visits to a handful of JBH stores that they were busier than ever. But the recent share price changes suggests someone is nervous.
The only subsequent thought I have had is that the high Australian dollar has resulted in price deflation, which JB Hi-Fi’s competitors will take advantage of and the company will have to respond to by lowering prices, putting pressure on gross margins. JB Hi-Fi remains at a discount to my current estimates of intrinsic value and as I just mentioned, I generally take advantage of the market and its Wallet rather than listen to its Wisdom.
Keep an eye on JBH and any news from tomorrow’s AGM in Melbourne particularly about margins, deflation and the Aussie dollar at 11.30am.
Posted by Roger Montgomery, 12 October 2010.
Postscript #2: JBH AGM notes. first quarter trading has improved. Total store sales are up 12.2% but behind BUDGET (not last year comprables) by 5%. JBH expects to make it up over CHristmas but evidently they didn’t mention the previous guidance of 17% growth in sales (perhaps this IS budget). Store roll out is on track and 18 additional stores are expected to be opened in the current financial year. They DID say that they are well placed to maintain margins despite discounting. Newspapers this morning point to a raft of new games to be released (JBH is the second biggest retailer of computer games) for Christmas.